[Mergers & Acquisitions Supplement] What's It Worth?

One of the biggest questions, if perhaps not the biggest question, when it comes to selling a pest control business is: “What’s it worth?”

This can be a tricky question to answer for PCOs who are looking to sell their business, with many factors coming in to play, and The Potomac Company’s Paul Giannamore attempted to tackle the issue during PCT’s Mergers & Acquisitions Virtual Conference in August 2012. Giannamore, managing director of the Potomac Company and veteran of the M&A scene, started off by drawing a clear picture of the stakes at play when a PCO decides to sell his or her business.

“As owners of private pest control businesses, you have two roles,” Giannamore said. “First and foremost, you’re an investor. You have significant concentration in your portfolio in that a lot of your personal wealth is tied up in the value of your business. Secondly, you’re a full-time business manager, responsible for setting strategy and organizing the resources and capabilities to serve the customer.”

When it comes to valuing a pest control business, Giannamore implored PCOs to put their “investor hats” on in order to get the most from the business they have worked so hard to see become a success.

Risk & Return. Generally, PCOs are no strangers to investing, Giannamore said. And in thinking like an investor, he said that two major concerns apply: risk and return.

“A lot of folks in the pest control space are wealthy and have outside investments, all sorts of speculative ventures,” Giannamore said. “Over the years, I’ve met a lot of them, and these guys tend to know everything about their other investments — they know what their potential return is, they have it squared away, but when it comes to their own businesses, they can’t answer these questions: What is their risk, and what is their return?”

As investors, PCOs must ask themselves if they are receiving an appropriate return on their investment, either in the form of dividends or capital appreciation, in light of the risk being taken, Giannamore said. “You get a return through your business, payment above and beyond your salary, and ideally you also get capital appreciation, your business increases in value,” he said. “When we’re talking about expectations, we’re talking about the future.”

The first component in determining the value of an asset, in this case a pest control business, is determining the expected cash flow to the owners, Giannamore said. And since this value is based on future cash flow, another equally important component is risk — the greater the risk of not receiving expected future cash flow, the lower the value.

The pest control industry stands out from other industries in that contractually recurring revenue, which is generated from monthly or quarterly service treatments, for instance, is something of a unique phenomenon. “If you’re in the pest control business, and the majority of your business is not recurring, you’re not really a pest control business, from a valuation perspective,” Giannamore noted. “You’re closer to a video rental store or a liquor store.”

This contractually recurring revenue is part of the reason why pest control businesses are valued at relatively high multiples of cash flow for their respective sizes, Giannamore said. The businesses are low-risk enterprises, with a future cash flow more certain.

Managing for Value Creation. There has to be a reason — or value — in purchasing a pest control business for the acquirer, and Giannamore spent a good portion of his presentation outlining exactly how, as a pest management professional, to create that kind of value.

He pointed to a stark anecdotal statistic that illustrated the importance of value — many individual businesses in the industry simply aren’t worth owning. “They’re not generating enough money to compensate their owners for actually owning those businesses,” he said. “At the end of the day you’re in business to create wealth for yourself, you want to create value for you and your family, you want to build wealth. Instead of waiting to plan for your exit, start planning your portfolio today and the biggest asset in your portfolio is your pest control business.”

Giannamore drew on the example of Orkin to show PMPs how that company measures shareholder returns on a day-to-day basis. “You need to do that,” he said. “Understand where you are today in terms of valuation and where you want to be in the future. Whether or not you want to sell a business five to ten years from now, it doesn’t matter, you need to understand where you are now and what you need your asset to be worth, and how you’ll get there.”

The kind of value that makes a company worth owning flows from the second “hat” Giannamore noted — that of a pest control business manager. As an owner and manager of a business, all the decisions you make will have an effect on value in some way, shape or form. “Every project you take on is either wealth-producing or wealth-destroying,” he said. “Everything you do affects value.”

Back to Basics. When it comes to value, there is one thing that is important above all, and it might sound like a familiar answer: the customer.

“The purpose of any business enterprise is, number one, to create a customer, and number two, to create value for that customer,” Giannamore said, suggesting a “back to basics” approach when it comes to properly determining value. PCOs go into the marketplace and create a service customers are willing to voluntarily pay for. “You create a perceived value, that customer pays you for that service, and as long as they’re paying you a price that is greater than the economic cost of producing that product or service, you have created value for yourself,” Giannamore said.

Pest control companies create more value by utilizing strategy, the importance of which Giannamore outlined by defining the Greek root word of “strategy,” stratego: “to plan the destruction of one’s enemies through effective use of resources,” with the importance hinging on “the effective use of resources.” Strategy provides three ways to compete, Giannamore said.

• Cost Leadership: Simply put, this is a “brain-dead” way to run a business from the perspective of most PCOs, Giannamore said. “There is room for one low-cost producer (and) one cost leader in any market.” When you’re up against the likes of Orkin, a major company that can control its costs, the cost leadership strategy is out for your average PCO.
• Differentiation: When the average consumer goes to look for a pest control firm to call, Giannamore said that person is typically inundated with generic, meaningless claims. “They’ll say they have licensed technicians, they use high-quality products, we’re the best in town, blah blah blah.” All of these may be critical success factors for any given pest control firm, but it is difficult for a customer to perceive value from such common and oft-repeated claims. Relating to a recent insect problem encountered by his father, Giannamore said, “My dad wasn’t able to perceive any value. He went with one of the big guys, because the private companies in his area blew it.” The takeaway for PCOs: differentiate your services from the competition, and create value for the customer.
• Focus: This is another way for PCOs to strategize, and to differentiate from the competition — it’s not necessarily competing as just another pest control company, but placing a hard focus on a specific segment of the industry. Giannamore drew on the example of The Steritech Group and its focus and commitment to the food-processing and food-safety sectors. Steritech sets itself apart from its competitors, and the company’s customers pay for it, Giannamore said. “It’s not necessarily doing something better, but doing things differently than your rivals.”

Translating Value. For pest control companies, it is important for the consumer to perceive value in the services you’re offering — as Giannamore put it, customers don’t care, or do not consider, whether or not your firm is making money, they care about whether they are getting value for their money. And from that perceived value comes the maintaining of a customer, and from that, a valuable business.

“You need to not worry so much about cost, but about creating value in the eye of the consumer, creating that customer and then maintaining that customer on a contractual basis,” he said. “Once you have created a customer and you’re providing value, then you have that machine that operates and continues to provide these services on a continuing basis.”

Again, it’s that recurring revenue that makes the pest control industry unique and why firms are valuable. And keeping up that recurring revenue stream requires a concerted effort at all levels of the business. “A pest control firm, as an economic asset, is a unique bundle of resources and capabilities and it is the job of the manager to organize those resources and capabilities to create value for the customer,” Giannamore said.

Standards of Value. Once the building blocks for value are in place, it’s time to ask the question: What’s it worth? To answer that, Giannamore asks another question first: To whom?

To get to the root of that second question, he outlined three standards of value:

• Fair Market Value (FMV): This is a hypothetical construct, and illustrates what the business is worth to the current shareholders. “It’s what a willing buyer and willing seller would transact at if neither are under any compulsion to do a deal,” Giannamore said. A common example would be the price per share of a publicly traded company.
• Investment value (IV): A “Beauty is in the eye of the beholder” situation, as Giannamore described it. This is the value to a particular investor based on individual investment requirements and expectations.
• Intrinsic value: A third type of value based on perceived characteristics inherent in the investment — but intrinsic value is not often applied to the valuation of private businesses, Giannamore said.

When selling a business, the seller should look to receive the investment value rather than the fair market value — and the buyer would like to purchase a business near the fair market value. This is why it’s important for a seller to find the right buyer, and it is ideal for the purchase price to fall into what Giannamore called the “value creation zone.” This is where value is created for both the buyer and the seller. “Let’s imagine a fair market value of $9.5 million, you take it out to market, solicit bids from acquirers, you have one that values at $10.5 million (investment value) — if that acquirer were to pay more, they’re now destroying value, they’re paying you more money than the transaction is creating for them,” Giannamore said. “And if you sell for less than $9.5 million, you’re losing money.”

The focus for the PCO on a day-to-day basis, though, should be on the fair market value of his or her company. While you can’t control what someone will pay you for your company (investment value), you can control risk, cash flow and growth rate (fair market value), Giannamore said.

Approaches to Valuation. Giannamore described two approaches to valuation that apply to the pest control industry: the income approach and the market approach.

Valuation hinges on an approximate measure of the company’s operating cash flow, based on data from said company’s records — this is the Earnings Before Interest, Taxes, Depreciation and Amortization, or EBITDA number. Giannamore noted that this is not an ideal metric for cash flow, but it is commonly used by advisers, and tends to overstate the economic benefit of owning the business in question. The next step is to take financial projections and move them forward in time to try to understand what the company will produce in the future, Giannamore said.

The income approach utilizes discounted cash flow analysis, a prominent valuation methodology used by private equity firms and most sophisticated public companies, Giannamore said. This approach projects cash flow into the future and discounts it by a rate that effectively quantifies risk, Giannamore said. He used the example of an average pest control company with around 70 to 80 percent recurring revenue, that had done $2.9 million in latest 12 month sales — a discount rate using the income approach, which generally uses a discount rate between 22 to 30 percent, establishes an enterprise value for this company at about $2.4 million (using a discount rate of 17.2 percent, or 82.8 percent of the firm’s sales figure for the last 12 months).

Next is to realize synergies between the company being valued and a potential acquirer — in Giannamore’s example, Orkin. If Orkin buys XYZ Pest Control, XYZ Pest Control becomes less risky by virtue of a decrease in its cost of capital now that it is part of Orkin. As well, staff synergies can be realized, and the value goes up. “This is assessing the situation and saying, ‘what could an acquirer do to this company to increase value,’” Giannamore said.

The market approach to valuation uses the economic principle of substitution — an acquirer would not pay more for your company than he or she would pay for an equally desirable alternative — this is relevant because it uses observable, factual evidence (other sales in the industry) to derive indications of value, Giannamore said. He added that the market approach is not a method used by sophisticated acquirers to value a company, but it is often used as a “sanity check” — an acquirer can compare their calculated enterprise value to other, similar sales.

Rules of Thumb. There cannot be a universal approach to all deals. Giannamore quoted the CEO of one of the top global pest control firms (who he left nameless) to illustrate that point: “We build complex transaction models on every single deal that we do, whether we are acquiring a $50,000 portfolio of customers or a $100 million business,” the CEO commented. That said, there are a handful of rules of thumb that can come in handy in the realm of valuation.

• The most acquisitive pest control companies are focused on financial returns and risk — the income approach allows these companies to measure financial returns.
• EBITDA multiples are often misleading. When a seller bases valuation purely on sales or EBITDA multiples, it often raises the question, “What are they trying to hide?”
• Returns drive deals, not revenue multiples. “There is an enormous difference between a $2 million in sales business with a 20 percent cash flow margin, 80 percent recurring revenue and growing 10 percent per year, and a $2 million in sales business with 10 percent cash flow margins and 50 percent recurring revenue and growing at 3 percent per year — but applying a revenue multiple, or dollar-for-dollar on revenue, would value both companies exactly the same,” Giannamore said. As well, it’s typical for owners to sell their businesses and inflate what they received when speaking of it in the future, so take everything you hear about valuation with multiple grains of salt.

When valuing a business, there are many factors to consider, and never will there be a single solution to every situation. But with some knowledge, you can find a way to get top dollar.

The author is associate editor of PCT magazine. He can be reached at bdelaney@giemedia.com.